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Inflation and deficit put rupee market on edge

01 Oct 2012

Rising inflation and a widening budget deficit are worrying India’s domestic corporate bond market. Unless the government acts quickly and decisively to address these problems, the country may even lose its investment grade rating, writes Jun Ebias.

The Reserve Bank of India, the country’s central bank, is in a bind. It would like to cut rates to stimulate growth, but with inflation expected to remain high for the bulk of the current financial year ending in March 2013, it has precious little room for manoeuvre.

A prolonged drought that threatens to cut agricultural production, higher commodity prices in the global market and a weak currency are all stoking inflation. So much so that the central bank is now prioritising putting a lid on inflation over pushing for growth, according to economists, analysts and bankers.

"The central bank has clearly indicated that it is willing to sacrifice growth in the short to near term in order to control inflation," says Gaurav Kapur, senior economist at Royal Bank of Scotland in Mumbai.

In July, the RBI raised its inflation forecast for the current fiscal year to 7% from 6.5%. At the same time, the monetary authorities cut the country’s growth estimate to 6.5% from 7.3%. While some economists see inflation hovering near the forecast, they doubt that the economy will expand as fast as the central bank’s estimate.

The combination of high inflation, lower growth and a widening fiscal deficit is keeping bond market participants on the edge, at a time when bank lending rates remain high.

Bigger deficit, lower growth

The RBI has kept its benchmark borrowing rate unchanged at 8% since the last 50bp cut in April, as policymakers wrestle with inflation. While the wholesale price index (WPI) softened to 6.87% in July — the first time it had fallen below 7% since November 2009 — economists say the outlook remains uncertain because food inflation is still high. WPI stood at 7.25% in June.

"Inflation will remain sticky at this level," says Indranil Pan, chief economist at Kotak Mahindra Bank in Mumbai. "Even though the headline number has come off, food inflation remains on the high side, which means that inflation expectations going forward will remain strong."

The inflation rate for food items, which account for nearly half of the WPI, was at 10.06% in July, slightly below June’s 10.81%, according to recent government data.

Economists expect the central bank to keep its key rates steady until the end of this year, and are betting that if inflation eases in the coming months, there is a chance that the policymakers could cut rates by 50bp next year.

Inflation is not the only problem that rupee bond issuers and investors are facing. The government’s rising budget deficit is another sticky issue — although they hope the country’s new finance minister Palaniappan Chidambaram will be able to resolve this soon. Chidambaram has returned to the post after vacating it in 2008 to become home minister.

The slowing economy, which is resulting in lower tax receipts, and a rising government subsidy on domestic oil prices are pushing up the fiscal deficit. Most economists and bankers estimate that the government will exceed its budget deficit target of 5.1% of GDP this fiscal year. Some economists expect the deficit to reach around 5.6% of GDP by the end of the current fiscal year, in March 2013.

The government is borrowing heavily in the domestic market to finance the widening budget gap, exerting upward pressure on domestic interest rates and making it more expensive for corporate borrowers to issue bonds to fund their requirements.

"The issuance of sovereign paper will remain high given the increasing sovereign deficit," says Karthik Srinivasan, a Mumbai-based analyst at ICRA, a local rating agency. "As a result, there is always that fear of crowding out for the private sector. The issuance of corporate bonds has been slowing down."

The government has targeted a record Rp5.69tn ($102.7bn) worth of borrowings this fiscal year to fund the budget deficit. Meanwhile, corporate rupee bond issuance so far this year has fallen 7% from a year ago, to $6.78bn, according to Dealogic data.

Most economists are predicting that the country’s gross domestic product will probably expand by less than 6% this fiscal year, well below the central bank’s 6.5% estimate. GDP grew 5.5% in April-June from a year earlier, latest government data showed. Growth in the same period last year was a heady 8%.

Limited demand

Like any developing country, India’s local currency bond market is dominated by issuance by the government and its related entities. Some bankers and analysts say public sector offerings account for around 80% of total outstanding bonds in the domestic market.

It’s easy to blame inflation and the budget deficit as the main culprits for the low corporate bond issuance in the country, but there are other factors too. Bankers and analysts say that there is little demand for issuers that are rated below double A, for example. That is largely down to regulatory rules that prohibit insurance companies from investing in rupee debt rated below double A, making the domestic market almost exclusively investment grade.

"It’s very difficult to place debt in the domestic market if it is below double A," says Vivek Rao, senior finance specialist for South Asia at the Asian Development Bank (ADB) in Manila. "There are hardly any takers. There is almost no liquidity for these issues."

The lack of investors for companies with ratings below double A is affecting investment in the country’s infrastructure projects. That is a serious problem, given the amount of cash that is needed to improve the country’s power, roads and transportation systems. The power outages that hit in late July underscored the need to bolster the country’s infrastructure facilities. In a recent report, rating agency Moody’s said that the Indian power sector suffered from aging and unreliable distribution networks. Power disruptions will further depress business sentiment, which is already hurting from slowing growth and the government’s inability to implement measures to revive investment, said Moody’s.

Given the lack of bond market demand, some infrastructure companies turn to banks for funding. But this presents other problems: loan rates are high, and banks have become more selective in extending loans to avoid a deterioration of their loan portfolios. On average, bank loans are 50bp-100bp more expensive than corporate bonds, bankers say.

Although there are obstacles to issuing low rated domestic debt, investors are increasingly prepared to look below the very top tier. Rupee bond issuance from triple-A rated companies accounted for nearly 80% of total offerings last year, says Rajiv Nayar, managing director for capital markets origination at Citi in Mumbai. But this has fallen to around 70% so far this year.

"We are seeing a gradual widening of investor interest and while triple A remains the dominant issuer rating, its share of total issuance is going down," says Nayar. "Over time, we expect the market to continue to evolve in this direction, with support from regulatory authorities.

"This change is not unique to India as investors globally are seeking higher yields and are prepared to invest in issues beyond the traditional strong investment grade issuers."

Debt raters raise the alarm bells

The pressure is now on India’s finance minister Chidambaram, who took office on August 1, to narrow the fiscal gap and minimise any risk that the country might lose its investment grade rating.

Earlier this year, Standard & Poor’s and Fitch downgraded their rating outlook on India to negative from stable, citing worries over the widening budget gap and weakening economy. S&P and Fitch rate the sovereign at BBB-, the lowest investment grade
rating.

Moody’s has kept its rating outlook stable, but it warned in August that the power disruptions in the country that affected 20 states and around 700m people had a credit negative effect on India’s economic activity.

In his first pronouncement as finance head, Chidambaram promised to find ways to address the ballooning budget deficit, which had already reached 51% of the full-year target after just the first four months of the current fiscal year. Chidambaram said he would work closely with the central bank to bring down inflation and interest rates. Until he makes progress with that, the market will remain on edge.
01 Oct 2012